Inflation targeting is a much better monetary policy than the gold standard. But that's not what this post is about.
Is there any fundamental theoretical difference between how monetary policy worked under the gold standard and how monetary policy works today for a modern inflation-targeting central bank? That's what this post is about.
If you believe that monetary theory fundamentally changed, or needed to change, when modern central banks abandoned the gold standard, then this post is for you.
[Update: on thinking it over last night, and reflecting on my own beliefs over the years, I should probably add that the question in this post ought to be directed at myself, as well as directed at others. I had always thought "Oh yeah, dropping gold changed everything". But other than making the basket much more representative and sensible, which matters massively in practical terms, did it really change things theoretically?]
1. Start with a monetary system where the central bank's paper money (or an electronic equivalent) is 100% backed by gold reserves, and each note can be redeemed at a fixed price for gold.
2. Now relax the assumption of 100% gold reserves. The central bank holds fractional gold reserves, with the rest of its assets being something else, like government bonds. If there's a demand to redeem notes, the central bank might have to sell bonds to redeem some of the notes, if it fears it might run out of gold reserves. And interest rates might rise if it does this.
3. Now take the limit of that system, as the percentage of gold reserves approaches 0%. There is indirect convertibility of paper money into gold. The central bank never actually buys or sells gold, but it buys or sells bonds to keep the equilibrium price of gold pegged, so that people can still swap their notes for gold in the open market at a fixed price.
4. Now replace the fixed peg with a crawling peg. The central bank allows the paper currency to depreciate at 2% per year against gold. The target price of gold rises at 2% per year.
5. Now replace that target price of gold with a target band. The price of gold can fluctuate either 1% above or 1% below that target price, at the central bank's discretion. The exchange rate of paper money for gold is a snake in an upward-sloping tunnel.
6. Now allow some base-drift. If the price of gold rises towards the top of the tunnel, the central bank may re-base the tunnel upwards. If the price of gold falls towards the bottom of the tunnel, the central bank may re-base the tunnel down. But any such re-basing is unbiased, so the expectation is always that the price of gold will rise at 2% per year from now on.
7. Now add silver to the gold. The central bank targets a weighted average of the price of gold and the price of silver. There's a synmetallic standard.
8. Now add a lot of other goods and services to the basket, along with gold and silver.
9. Now remove any goods and services that are not included in the CPI basket of goods, and weight the remaining goods according to their weights in the CPI.
[Update: Maybe add 10: Since some goods in the CPI basket have sticky prices, that need time to change, the central bank switched to pegging the expected future price of that basket.]
We now have a modern inflation-targeting central bank.
(For a price level path targeting central bank you can delete step 6.)
At what point in the above steps did monetary theory need to fundamentally change?
This post was inspired by the second of two very good recent posts by Edward Harrison. (The first is here.)
Worthwhile Canadian Initiative 
Interesting!
Promising to convert to something useless (gold) is both easier (less tied to real lives) and for the same reason less effective (less relevant to real lives) than promising to convert into something that people really need. How about a health standard? 1 Dollar promises to buy 1 day’s worth of state of the art medical care.
Just a thought. Off to bed…
So if CPI targeting isn’t really that far from the Gold Standard, then that would explain why the Left sees monetary policy as a subset of the Right’s agenda to promote inequality. The Gold Standard was the target of much Lefty criticism before the Great Depression sunk the concept.
It would also explain why Nick can’t tolerate the Lefty position that Central Banks are irrelevant or tangential when the Left Agenda is political.
@Oliver:
Makes much less sense in countries with single-payer systems, that is anywhere except the US.
Re-frame: targeting the price of gold and targeting the price of the CPI basket are just 2 out of the endless possible things you can do with a fiat currency.
i agree completely. However, there is a world of difference between being short a physical (scarce) commodity with fixed supply (basically inelastic supply) and a financial one (whose supply is essentially infinite and can be suplied elastically). If you have to go out and physically procure and deliver it upon redemption you are faced with inelastic supply (been there, done that). Even if you fix a basket of goods, if you are forced to actually redeem or deliver those goods (yes, a deliverable basket of CPI) then the CB may be faced with inelastic supply. the difference is that even though the central bank targets the CPI (gold price, whatever) it does so by supplying financial bonds (claims) which it has (virtually) infinite supply of.
K: OK. I think I maybe get it. Let me ask a different but related question: the stock of money is a stock, and the flow of consumption is, urrrr, a flow. Just suppose everyone wanted to convert his base money immediately on CPI goods. It can’t be done. You can’t spend (say) 10% of GDP in 1 week. Interest rates would go very high, to try to persuade people to convert their base money into a stock of bonds, not into a flow of consumption. The central bank might go bust, because the market price of its bonds would fall as interest rates increased.
http://www.cnbc.com/id/46970524
Maybe, just maybe, the theoretical difference comes when we target prices that are sticky, as opposed to targeting prices that are perfectly flexible?? So it’s at step 8 that the theory has to change?
Bill @8.32am. That is a very good comment, if a little hard to follow. I think you are right.
Short oversimplified version of Bill:
1. A world in which most of the stock of gold is used as money is theoretically very similar to a world in which the central bank targets the stock of paper money.
2. A world in which most gold is used for industrial purposes and paper is pegged to gold is theoretically very similar to inflation targeting.
At what point in the above steps did monetary theory need to fundamentally change?
1. Start with a monetary system where the central bank’s paper money (or an electronic equivalent) is 100% backed by gold reserves, and each note can be redeemed at a fixed price for gold.
…
3. Now take the limit of that system, as the percentage of gold reserves approaches 0%. There is indirect convertibility of paper money into gold. The central bank never actually buys or sells gold, but it buys or sells bonds to keep the equilibrium price of gold pegged, so that people can still swap their notes for gold in the open market at a fixed price.
Although some comments are focusing on the inability to buy or sell the CPI, the breakdown occurred earlier
in your logic. You leaped from a fixed price to an equilibrium price at step 3. That won’t work in the real world (which theory should presumably reflect). Why: open market operations in the local market are unlikely to be enough to stabilise the price of a globally traded commodity in local currency terms.
As an example, suppose Canada had the idea to target the gold price in CAD terms without going into the gold market. Then assume the price of gold rises 10% in USD terms because of foreign buying. According to your scenario, the Bank of Canada would have to raise rates sufficiently to increase the value of CAD versus USD by 10%. That would presumably take a lot of rate hikes. Since this rate hike policy will be damaging to the Canadian economy, CAD could drop in value faster due to investor flight than would be made up by people positioning for interest rate differentials. If this policy damages the economy enough (e.g., policymakers being idiots destroys the incentive for fixed investment), CAD may never restore its original exchange rate.
Therefore, there is no reason to expect that open market operations could restore the CAD gold price on any reasonable interval, which makes a mockery of the assumption that the “equilibrium” price is fixed.
“Suppose initially in step 1 the central bank didn’t actually own any gold, simply because it didn’t own a strong enough safe, but gave anyone who wanted to redeem their notes in gold a sufficient amount of copper that they could sell the copper for the requisite amount of gold in the open market.”
Ok, but I’m not sure why this is relevant. Then you have bank money convertibility which is settled with an amount of copper. The redemption amount is manipulated by the central bank to ensure that it’s liabilities trade in the secondary market at a set ratio to the gold price.
That doesn’t change the fact that the convertibility feature that modern central bank’s provide to holders of their liabilities is settled with bonds, not CPI. The fact that people can sell these liabilities in the secondary market for a CPI basket is not convertibility. Convertibility is a feature that characterizes the financial relationship between a liability issuer and holder in the primary market. It allows the issuer/holder of an asset to destroy that issued asset rather than allow it to continue hot-potatoing around in the secondary market. In the case of central bank money, it is withdrawn/destroyed in the primary market by conversion into bonds, not in the secondary market by an exchange of CPI baskets. You don’t convert money in the secondary market, you sell it.
JP: but under the gold exchange standard, AFAIK, most convertibility was in practice indirect. Central banks mostly used open market operations in bonds, rather than gold market operations. They had to, because they had fractional reserve banking. Plus, AFAIK, non-US (or earlier, non-UK) central banks had indirect convertibility into gold. You exchanged your local currencies for USD (or Sterling), which in turn was converted into gold.
bond-trader. Your argument seems to imply that the gold standard was impossible, with fractional gold reserves. Now sure, it was vulnerable to speculative attacks, but it did in fact exist.
It just wasn’t as robust as we thought it was, witness WWI and the tribulations of the 1920’s where it was a curse.
Ryan: ” FWIW…”
It’s worth a lot. It means the number of people who apparently agree just doubled. I googled the Randian take on inflation and it sounds similar, except she seems to think that money should be a substitute for the consumption basket. I think it should be capital assets, or equivalenty, I think it should be a proxy for the intertemporal consumption basket, not just the current one.
Nick@7:12,
Agree with all of it. The only thing I’d add is that the CB can be made whole via taxation, assuming the losses aren’t too great. But if the quantity of money and debt is too high, it may cause an impossible tax burden and the target will fail.
Nick, using your definition of convertibility, which I find somewhat peculiar, I agree with you. Convertibility to you seems to mean just selling in general.
Using my definition, can you see why I’d disagree with your point “most convertibility was in practice indirect.”? To me, indirect equates to transactions in the secondary market. Direct is the primary market. In finance, convertibility by definition is not a mere sale, it occurs when the original issuer is forced to redeem by the holder, and that only happens in the primary market ie. directly. You can’t have conversion in the secondary market. The phrase “convertibility was in practice indirect” is therefore nonsensical. The secondary market is where on-trading of already-created assets occurs, not conversion.
Anyways, ignoring all that, and using your wording now. Would you agree that indirect conversion of modern money into the CPI basket is achieved by direct conversion of central bank money into bonds via open market operations (and the threat thereof)? You said earlier “We have gone from (direct) convertibility into gold to (indirect) convertibility into the CPI basket.” In my earlier posts, I was just pointing out that we’ve gone from (direct) convertibility into gold to (direct) convertibility into bonds.
JP:
What’s the difference if one kind of dollar promises redemption for the CPI basket, and another promises redemption for the CPI basket or something of equal value, including bonds? Both meet the usual definition of “convertible”.
JP: “Would you agree that indirect conversion of modern money into the CPI basket is achieved by direct conversion of central bank money into bonds via open market operations (and the threat thereof)?”
Yes.
BTW, I think my usage of the term “indirect convertibility” is standard. I didn’t invent it.
My classes are now over, and exams haven’t started yet, so I’m going to be away from the computer for a few days to take a needed break. Have fun.
Nick Rowe:
bond-trader [sic]. Your argument seems to imply that the gold standard was impossible, with fractional gold reserves. Now sure, it was vulnerable to speculative attacks, but it did in fact exist.
The Gold Standard relied on the banks having currency and gold reserves to defend parities; your example had no reserves. Normally, speculators would act to stabilise gold parities on their own. But they would only do that if the (collective) central banks would act to defend those parities, and the reserve positions remained credible. Central banks did often have to launch coordinated moves to defend various parities of the weak links of the system (typically trade deficit countries). I re-read Eichengreen’s “Golden Fetters” recently, and there is a long set of discussions about this point. Your assumption that you can progressive lower gold coverage ratios and still have a credible gold peg is thus suspect. (If a private actor could take out your gold reserves single-handedly, your gold peg would last roughly until lunch time.)
A country cannot peg a minimum value in an external currency without having reserves to back it up. (You can stop appreciation, as Switzerland is currently doing.) If nobody wants to own your currency (e.g., Zimbabwe), it’s going to lose value in nominal terms versus external pairs regardless of your domestic interest rate policy. (Of course, even if you have reserves, currency pegs still don’t last forever.)
Eventually, you can deflate your economy enough that purchasing power parity concerns should restore the original parity. But that process can take up to 20 years in practice (domestic prices are sticky to the downside, yadda yadda). Meanwhile, a thinly traded international commodity like gold could be rising in the foreign currency’s terms (think Peak Gold), so a gold target could recede faster than you can deflate to keep up.
A regime in which a price which is pegged (within a window) each and every day (as per the Gold Standard) is not the same thing as a regime where the price which might drift back to its original level within 20 years.
Mike/Nick, then we just have different terminology. Your’s might be standard in the monetary econ literature, but convertibility means something quite different in the financial world. In the end we’re arriving at the same idea.
DWB: “the difference is that even though the central bank targets the CPI (gold price, whatever) it does so by supplying financial bonds (claims) which it has (virtually) infinite supply of.”
It doesn’t have an infinite supply of bonds. Just like classical central banks who had to buy gold in the secondary market, modern central banks must buy bonds in the secondary market along with everyone else. Sure, gold markets tend to be less broad and liquid than bond markets. But rather than a world of difference, I’d describe it a slightly different shade, and certainly not enough to contradict Nick’s progression from 1-10.
Dan K: “The salient fact about the gold standard is that the currency is legally redeemable in gold, and so the government actually has to own lots of gold. And gold is something the production of which the government does not fully control…I can’t take my US dollars to a pork belly bank where they are guaranteed to be redeemed in bacon. What the government does is to try to assure that the currency will continue to be accepted. It does this by enforcing various kinds of laws which require people to transact business in that currency…In the gold standard era the government dependently piggybacks on the fact that gold was already generally acceptable as a medium of exchange, for historical reasons that had little to do with the government’s own decisions. ”
The salient fact about the modern standard is that the currency is redeemable in bonds, and so the central bank has to own a lot of bonds. Bond production is something which the central bank has no control over. The only difference therefore between the gold standard and the modern bond standard is we’ve switched redemption medium and allowed the redemption price to float. That’s why the theory has remained constant, though details have changed, as Nick points out.
Just like a gold standard bank, a modern central bank doesn’t need enforcement of laws in order for it’s currency to be accepted. The fact that one offers convertibility into gold and another into a floating quantity of bonds (not porkbellies) is sufficient reason for both to remain credible.
While in the gold standard era central banks could piggyback on the fact that gold was already generally acceptable and had value, modern central banks can piggyback on the fact that bonds are already generally acceptable and have value. Nick’s progression from 1-10 stands as far as I can see.
It’s possible to think about contemporary fiat money systems in the same way that one thinks about gold-standard systems.
This kind of approach misses the point however that fiat money makes it possible to do things in a very different way.
In a fiat system the government/CB essentially has a magic goldmine that can produce an infinite amount of gold.
If that’s no different to a gold standard system with a limited supply of gold then I don’t know what is.
In this magic goldmine system state borrowing isn’t really necessary.
Financing government deficit spending through money creation (or CB “monetising” government debt) isn’t necessarily more inflationary than deficit spending funded by bond issuance.
This is because interest rates can be determined by paying interest on reserves rather than by selling/buying bonds. This means the overall quantity of reserves is not important – even if the government chooses to pursue a policy of controlling inflation through interest rates.
Piling up excess reserves does not necessarily make it easier for banks to lend, nor does it increase the availability of currency (cash) for withdrawal by depositors (CB always makes cash available anyway).
Any level interest rate can be sustained through the paying of interest on reserves, regardless of the overall quantity of excess reserves in the system.
Alternatively the interest rate can be allowed to fall to zero.
With a fiat money system taxation can be viewed as a means of regulating the currency’s value rather than as a means of raising revenue.
Thus it might be more sensible to control inflation mainly through fiscal policy, and to keep interest rates stable (thereby avoiding the sledge-hammer, one-size fits all approach of monetary policy).
Fiat money also implies that high government deficits are not necessarily unsustainable, so long as government spending is not overly inflationary, wasteful, inefficient or harmful in some other way.
Government deficit spending always has the potential to be inflationary, but whether it is financed through bond issuance or “money-printing” is not fundamentally important.
For these reasons magic goldmine is very different to ordinary goldmine.
“Short oversimplified version of Bill:
1. A world in which most of the stock of gold is used as money is theoretically very similar to a world in which the central bank targets the stock of paper money.
2. A world in which most gold is used for industrial purposes and paper is pegged to gold is theoretically very similar to inflation targeting.”
Both types of central banking from the #1 above have the advantage of requiring little equity and having a very low level of risk. However, the services they provide fail the market test, so we do not observe #1 often in practice (Volcker tried to move into the direction of #1, but this was temporary). #1 have the current day private sector equivalents of physical gold ETFs and closed-end currency mutual funds. Their impact is tiny.
#2 is much more useful and popular, having better risk/reward ratios, Rothbardian moralizing notwithstanding.
I should add that owning a government bond does not necessarily restrain or ‘hold back’ potential spending by bond owners, as bonds can be sold quickly and easily.
piling up excess reserves does not make it easier for banks to extend credit as reserves are necessarily always available under the current system. What’s important is the price, i.e. the interest rate. This can be set by paying interest on reserves rather than through OMOs.
The efficacy of controlling inflation through interest rates should also be questioned – does it actually deliver optimal outcomes, or even work that well?
Zero interest rates (or very low rates) combined with a different approach to fiscal policy and regulation might actually deliver better outcomes along with the desired level of (low) inflation. Very low rates are not necessarily stimulatory in the way that is usually assumed, given that they reduce interest income.
Let’s say we’re on a ‘CPI standard’.
The main difference I would say with the gold standard is that, as I said above, the government is not really revenue-constrained under a fiat money system.
As such the only real financial constraint it faces is inflation. This means government has to ensure that its spending doesn’t lead to inflation, but doesn’t have to worry about ‘going bust’ or ‘running out of money’, in the traditional sense. Similarly, it needs to be careful that it’s spending is not overly wasteful or inefficient, as this could lead either to inflation or to other structural and behavioural problems in the long term. It also needs to be able to carry out an appropriate taxation policy so as to be able to regulate the basic demand for/ value of the currency.
The central bank can also try to ensure the inflation target is met by setting interest rates correctly. It has the option to set this rate by paying interest on reserves rather than through open market operations.
As such government debt is not necessary, either for the government to deficit spend, or for the CB to set interest rates.
Either we can have a system in which the government issues new money directly, one in which the CB buys government debt as it seems fit, or one in which it buys all government debt and simply pays IOR.
In each case the money needed is simply dragged out of the magic infinite gold mine.
There is no need to worry about bankruptcy in the traditional sense because the magic goldmine never runs out of new money.
So policy, both fiscal and monetary, can be properly conducted to achieve optimum outcomes (max output/ low inflation) without having to go through periodic bouts of deficit/debt hysteria. Government and central bank can focus on real problems rather than having nightmares about phantom bond vigilantes.
This is potentially quite different to a perennially dysfunctional gold standard system, in which bog-standard gold mines consistently fail to produce the right quantity of gold at any given point in time.
Magical infinite gold mines are much better, if they’re used properly. They mustn’t be abused however, or they could disappear in a puff of smoke!
Nick:
bond guy is more correct than he suspects. His posited case is not theoretical, that is precisely what happened to the USD/CAD exchange rate in the late 1940’s. Immediately after WWII Canada and the United States were the only two industrialized nations that dealt with each other on an equal basis in money matters; Canada was not in debt to the US because we never participated in Lend-Lease, there had been political conferences during the war between Mackenzie-King and Roosevelt on this very point. Mackenzie-King convinced Roosevelt that placing a debt yoke on Canada was counter-productive and useless and would only injure the American reputation and their interests in Canada.
So the USD/CAD rate, uniquely, was determined according to trade flows alone, except that like everyone else it was fixed by Bank of Canada fiat until 1950.
In the late 1940’s there was market pressure to devalue the CAD against the USD, of course this led to repeated intervention and threatened exhaustion of Canada’s reserves of USD and gold. Of course we could have implemented capital controls, but we wanted a free market in investment more than we wanted a stable exchange rate. We could have changed monetary policy but we wanted an accommodating, independent monetary policy and nobody in this country wanted to choke off the post-war boom, not after living through the Depression and years of war. We wanted to enjoy the good times, not end them over a technical exchange rate.
Early on we encountered the Iron Triangle of capital controls, fixed exchange rates and independent monetary policy. We chose free capital flows and independent monetary policy and therefore had to float. 1950-62 was marked by exchange stability and economic prosperity so the governing elite in this country learned that fixed exchange rates and/or a gold standard was undesirable and unnecessary.
“This kind of approach misses the point however that fiat money makes it possible to do things in a very different way”
Y, you can still use Nick’s progression-style of getting his point across and avoid missing the point you are trying to make.
Take a gold standard in which the convertibility of central bank money is set at a certain quantity of gold ounces. Say the central bank offers the government an unlimited line of credit. As the government spends through its central bank account, the public bring central bank money back to the central bank to be redeemed for gold as they don’t need that quantity of cash on a day-to-day basis. The bank’s gold reserves start to diminish and the credibility of the peg is drawn into question. In order to protect reserves and defend the gold peg, the government raises taxes, drains excess cash, and sends it to the central bank to be destroyed. The race for gold is dissipated and the peg to gold remains.
Now take a modern central bank that provides unlimited lines of credit for government. All that’s changed is the redemption media is now bonds via open market operations, not gold. And the peg isn’t fixed, it floats so as to force central bank money to fall in value at 1-3% or so a year.
Obviously modern central banks don’t offer unlimited lines of credit. So while it is interesting to consider the possibility, Nick’s way of explaining things resembles reality.
While we can speak of 100% redeemable currency, that does not mean all debts can be paid. Someone that owns then sells an asset financing the sale creates debt but no base money and someone that pays off their debt destroys it without affecting base money. This can create temporary cycles as lending standards relax then tighten even if money is fully convertible and debts that looked payable when created can fail to be so over the fullness of time. Nor would debts created in such manner necessarily raise interest rates or their destruction lower them since they are in soft money or income flows. A 100% reserve turns banks into depositories but cannot save the economy.